Spain in crisis: Everything you need to know

Crushed underneath the weight of non-performing real estate loans and an increasing number of other troubled assets, Spanish banks are teetering on the edge of collapse. And with market pressures mounting from all sides, the challenge for the Spanish government is to extricate itself from ties to the fragile banking sector.

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The Spanish government has tried over and over again to sustain the Spanish banking sector through mergers arranged by the Fund for Orderly Bank Restructuring (FROB), set up with €9 billion ($11.3 billion) in guarantees from the Spanish government back in June 2009. The fund was supposed to be able to issue €99 billion in debt when it was initiated, but as concerns in Spain have mounted, so have borrowing costs for the sub-sovereign, government-backed FROB. Thus it faces difficulties finding financing in the markets.

Right now, FROB has €5.3 billion in available funds without issuing more debt, after providing funds to stabilize the numerous mergers of Spanish savings banks (cajas). That funding pales in comparison to the needs of just Bankia—Spain’s failing, third-largest bank and the biggest holder of real estate assets—which last month asked for €19 billion in government funding to stay afloat. Everything You Need To Know About The Failing Spanish Bank Bankia >

EU leaders have ruled out permitting the FROB or the Spanish government to issue more debt to support Bankia, as this would likely inflate the government’s already high borrowing costs. Thus, it seems there is little choice for Spain but to turn to international organizations for help.

As it stands, Spanish PM Mariano Rajoy has not officially asked for help from either the European Union or the IMF. While it is rumored that they are seeking some kind of aid behind closed doors—and that both EU leaders and the IMF are making contingency plans—no matter who lends them money, they are desperate for any plan to include as few conditions for the Spanish government as possible.

Unlike the problems of Greece and Portugal, most of Spain’s problems are caused by a housing bubble and not excessive government spending. And unlike Ireland, Spanish banks’ non-performing loans—and thus the size of any proposed bank bailout—amounts to a significant, but relatively small percentage of GDP.

While a few years ago raising Spain’s debt-to-GDP ratio by about 10 percent in order to provide banks with public funding might not have raised too many eyebrows, but now it is probably not feasible. Fear in the markets would push Spanish borrowing costs to unsustainable levels and would transfer even more risk from the Spanish financial sector to the government itself. That could render the country unable to access funding markets.

Both Spanish and EU leaders want to avoid any bailout in which the IMF is involved, as its aid would entail serious restrictions on Spanish government policy. And with the ECB not permitted to directly bail out Spain’s banks, it’s looking like this money will end up coming from the EFSF or ESM, Europe’s temporary and permanent bailout funds (respectively). The latter has not yet been ratified, so there is some question as to whether this mechanism would even be up and running in time to help Spain.

The last thing EU leaders need is another country on an IMF plan.

Currently, those funds are not allowed to provide bailouts directly to banks. And even if the bailout were sanctioned through the FROB, it is likely that this arrangement would face legal issues because Spain is not officially on a bailout program. EU leaders will do anything they can to prevent this from happening, because such a formal acknowledgment would likely drive fear in the markets and impose too many rules on the Spanish government.

Right now, the IMF is assessing the funding shortfall for the Spanish banking system, estimating how much money will be needed to keep it afloat. According to reports, they have come up with a number around €40 billion, although economists believe the real costs of keeping the Spanish banking sector functioning could cost four times that. They expect to release a report on Monday detailing these costs, and EU leaders will likely be there to provide it via the FROB to the banks.

The terms of this agreement, however, are still very much up in the air. On one hand, Germany and the rest of the FANGs (Finland, Austria, the Netherlands) would like to gain some control over how Spain goes about fixing its banking problems.

At the same time, Spain’s recession is largely cyclical. In 2011, the Spanish government had a lower debt-to-GDP ratio than Germany—68.2 percent to 81.5 percent. Spain feels—and rightly so—that the markets have assaulted it out of fear rather than on real concerns about solvency. Indeed, with its own currency, Spain could perhaps have fought its housing bubble much like the United States did.

As the IMF concludes its assessment of the funding needs of Spanish banks, Spanish and EU politicians are playing a fierce game of brinkmanship. The eurozone can’t afford to lose Spain it would be devastating for Spain to leave the euro, but the power structure of the ultimate deal reached by the two parties could influence whether or not the Spanish economy is able to recover quickly from its banking sector woes.

Regardless of this power play, there is a positive side to what’s going on here. First, a Spanish bailout that successfully separates the banking system from the government will not only take some of the pressure off Spain. It is the first step towards a true European banking union, as it centralizes some control of the banking sector with European authorities. Further, it forces the FANGs to make some difficult concessions on fiscal integration, because Spain is too big to fail.

That said, it won’t be an easy road to a bailout plan, and the ensuing drama will likely cause some significant shocks in the markets. Ultimately, however, there is little chance this doesn’t get worked out.

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